FM11 Ch 20 Lease Financing

Types of leasesTax treatment of leases Effects on financial statements Lessee’s analysis Lessor’s analysis Other issues in lease analysis CHAPTER 20Lease Financing... The lessee

Types of leases

Tax treatment of leases

Effects on financial statements

Lessee’s analysis

Lessor’s analysis

Other issues in lease analysis

CHAPTER 20Lease Financing

The lessee , who uses the asset and

makes the lease, or rental, payments.

The lessor , who owns the asset and

receives the rental payments.

Note that the lease decision is a

financing decision for the lessee and

an investment decision for the lessor.

a lease transaction?

 Operating lease

 Short-term and normally cancelable

 Maintenance usually included

 Financial lease

 Long-term and normally noncancelable

 Maintenance usually not included

 Sale and leaseback

 Combination lease

 "Synthetic" lease

What are the five primary lease types?

Leases are classified by the IRS as either

guideline or nonguideline.

For a guideline lease, the entire lease

payment is deductible to the lessee.

For a nonguideline lease, only the

imputed interest payment is deductible.

Why should the IRS be concerned about

lease provisions?

purposes?

For accounting purposes, leases are

classified as either capital or operating.

Capital leases must be shown directly on

the lessee’s balance sheet.

Operating leases, sometimes referred to

as off-balance sheet financing , must be disclosed in the footnotes.

Why are these rules in place?

How does leasing affect a firm’s balance sheet?

Leasing is a substitute for debt.

As such, leasing uses up a firm’s debt capacity.

Assume a firm has a 50/50 target

capital structure Half of its assets

are leased How should the remaining assets be financed?

a firm’s capital structure?

If the equipment is leased:

Firm could obtain a 4-year lease

which includes maintenance.

Lease meets IRS guidelines to

expense lease payments.

Rental payment would be $260,000

at the beginning of each year.

Assume that Lewis Securities plans

to acquire some new equipment

having a 6-year useful life.

Other information:

Equipment cost: $1,000,000

Loan rate on equipment = 10%

Marginal tax rate = 40%

3-year MACRS life.

If company borrows and buys, 4 year maintenance contract costs

$20,000 at beginning of each year.

Residual value at t = 4: $200,000

Time Line: After-Tax Cost of Owning

(In Thousands)

0 1 2 3 4

AT loan pmt -60 -60 -60 -1,060 Dep shld 132 180 60 28 Maint -20 -20 -20 -20

Tax sav 8 8 8 8

NCF -12 60 108 -12 -912

Note the depreciation shield in each

year equals the depreciation expense times the lessee’s tax rate For Year 1, the depreciation shield is

$330,000(0.40) = $132,000

owning cash flows, when discounted

at 6%, is -$591,741

Leasing is similar to debt financing.

The cash flows have relatively low risk; most are fixed by contract.

Therefore, the firm’s 10% cost of debt is

a good candidate.

must be recognized, so the discount rate is

10%(1 - T) = 10%(1 - 0.4) = 6.0%.

Why use 6% as the discount rate?

NAL = PV cost of leasing - PV cost of

Note that we have assumed the

company will not continue to use the asset after the lease expires; that is, project life is the same as the term of the lease.

What changes to the analysis would

be required if the lessee planned to continue using the equipment after the lease expired?

The discount rate applied to the

residual value inflow (a positive CF)

should be increased to account for

the increased risk.

All other cash flows should be

discounted at the original 6% rate.

Assume the RV could be $0 or

$400,000, with an expected value of

$200,000 How could this risk be

reflected?

(More )

If the residual value were included

as an outflow (a negative CF) in the

cost of leasing cash flows, the

increased risk would be reflected by applying a lower discount rate to

the residual value cash flow.

relatively low risk, and hence would

be discounted at the 6% rate.

What effect would increased uncertainty about the residual value

have on the lessee’s decision?

The lessor owns the equipment when

the lease expires.

Therefore, residual value risk is passed

from the lessee to the lessor.

Increased residual value risk makes the

lease more attractive to the lessee.

the lease transaction?

To the lessor, writing the lease is an

investment.

Therefore, the lessor must compare

the return on the lease investment

with the return available on alternative investments of similar risk.

$280,000 rental payment instead of

$260,000.

All other data are the same as for

the lessee.

Assume the following data for

Consolidated Leasing, the lessor:

(In Thousands)

0 1 2 3 4 Cost -1,000

Dep shld 132 180 60 28 Maint -20 -20 -20 -20

 The NPV of the net cash flows, when

discounted at 6%, is $25,325

 The IRR is 7.46% .

 Should the lessor write the lease? Why?

With lease payments of $260,000, the lessor’s cash flows would be equal, but opposite in sign, to the lessee’s NAL.

A cancellation clause would lower the risk of the lease to the lessee but raise the lessor’s risk.

increase the annual lease payment or

else impose a penalty for early

cancellation.

What impact would a cancellation

clause have on the lease’s riskiness from the lessee’s standpoint? From

the lessor’s standpoint?

Do higher residual values make

leasing less attractive to the lessee?

Is lease financing more available or

“better” than debt financing?

Is the lease analysis presented here applicable to real estate leases? To auto leases?

(More )

Would spreadsheet models be useful

in lease analyses?

attractiveness of leasing? Consider the following provisions:

Investment tax credit (when available)

Tax rate differentials between the lessee and the lessor

Alternative minimum tax (AMT)

Provision of maintenance services.

Risk reduction for the lessee.

Project life

Residual value

Operating risk

Portfolio risk reduction enables lessor to

better bear these risks.

owning is less costly than leasing Why, then, is leasing so popular?